Wanted: A new economic theory

Andrew Boughton with Michael West

This special feature is written by Andrew Boughton* with additional reporting by Michael West

Now that Prime Minister Kevin Rudd has hailed in his "Monthly'' essay a new political era of ''social capitalism'' and embarked on another stimulus package it merely remains to find an economic theory to accompany it.

Economics has failed manifestly to see the global financial crisis coming. Only those once derided as doomsayers and crackpots were anywhere near the mark. An entire generation of richly-remunerated experts got it wrong, once again.

Even now there is a reluctance to accept that the Global Financial Crisis is, as much as anything, just one big bad property bust. When the economy was veering towards its last meaningful recession in this country in 1991 - another property bust - the pundits were collectively predicting growth of 2%-plus. The IMF, OECD, market economists, government forecasters, you name it.

They were 2% too high. There was recession. Le plus ca change.

Capitalism has always had a single point of failure: the interaction of real estate markets and finance.

Parallel universe

Although this had often been noticed - even as far back as ancient Rome where real estate booms came and went - it had never been integrated with macroeconomic theory. The issue was sidelined, somewhat perversely, in 20th century economics, which had pursued 19th century thought ever more deeply into an obsession with gross output and consumption. In the middle of Paul Samuelson's "Economics", the thousand-page Keynesian textbook which has been a staple for almost every student in high school and university, the impact of real estate slumps on recessions was noted in a single paragraph, and dismissed. There is no way of connecting financial shocks with Keynesianism, it's a parallel universe.

Citing the work of Hawtree, Pigou and Robertson last century, Professor Charles Kindleberger argued that ''the neglect of the instability of credit began by and large with the depression of the 1930s, with the Currency and Banking schools converted to monetarists and Keynesians''. More specifically, he claimed that Keynesian and monetary theory are ''incomplete'' and ''misleading'' for leaving out ''the instability of expectations, speculation and credit and the role of leveraged speculation in various assets''.

In the 1960s, JP Lewis observed, in "Building Cycles and Britain's Growth", that ''Whereas many books and papers written by economic historians emphasise the role of credit ... economic theorists have strangely neglected them. Jevons, Hawtree and Robertson ... have made notable contributions in this field. But the Keynesian and post-Keynesian analysts have been so concerned with manipulating aggregates, and producing bold theories in terms of well-defined macrorelationships, that such awkward concepts as credit and credit shocks have slipped into the shadows of our thought, and create positive nightmares when they re-emerge.''

It has only been economists on the far political left, ironically, with their predilection for questioning fundamentals, or regulatory economists and industry consultants like Lowell Bryan at McKinsey's in New York - practical advisers to banks and governments - who have shown much interest in the idea of recessions as property cycles and credit shocks.

And even now, mainstream economists are yet to alter their views on macroeconomics to that extent. Economics is far too political, and its practitioners far too personally invested. They already know what causes recessions - the left knows it's the policies of the right and the right knows it's the left. Yet the tide still comes in and goes out.

Where regulators fail

The real reason regulation doesn't avert recessions is threefold.

First, there is no accepted macro-economic theory which sees real estate cycles as a cause of recessions.

The oracles of market risk, economists, still rely on trends in output and consumption as the entrails foretelling the future of property markets, so they can only predict downturns at the eleventh hour. For the banks, a long lead time is required for effective risk management, and too late is too late.

A second and related issue is that for specific transactions, no one owns the right to second-guess markets. No matter how close we seem to a major bust, a valuation is always valid at the time it was made, because it references the market. That value is written in stone, until it dissolves in a crash, and only then does it seem it was written in water. Credit risk has no grounds to second guess future real estate values at any stage of the cycle.

Third and most importantly, rapid increases in real estate prices damage the real economy in a number of ways including, ultimately, the real estate and construction sectors themselves, which are central to that ''real economy''. The cost increases in real estate do not all feed back into official inflation rates, which determines interest rates, while inflated values leverage more credit.

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So price increases at the core of our economy are not effectively counterbalanced by interest rate adjustments. Yet if they were, our system might equally fail, because real estate is a compound entity with many dimensions, and is not subject to the same principles of efficiency or supply and demand as, say, factory or farm output.

Real estate is completely unlike any other economic good, being a product, a cost, an asset, an investment avenue, a basic need on a par with food and water, a form of infrastructure and the staple for all financial institutions. It is all these things. The fact that an array of people make money in a boom period makes price appreciation look good until the underlying decay from all the other attributes of real estate takes off the shine. And price booms are hard to fix with the current tools of financial regulation, which is why the cycle recurs in advanced urban economies.

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So equally, two things are certain. Economic theory has failed to forecast crises with weary regularity, and regulation has failed as a prophylactic. The boom always busts.

Despite this failure though to avert crises, macroeconomic theory is remarkably resilient. The reasons are political and personal, and probably habitual. Although proven ineffective and just plain wrong, time and again, John Maynard Keynes offers a useful cover to governments for monetary and fiscal intervention - a valuable thing in times of crisis.

Keynes validates the mandate for the US to use the World Bank and the IMF as tools for international diplomacy. He lends radical economists a foundation to change capitalism. And into the bargain, he gives professional and academic economists a good gig. So don't count him out just yet.

Down for the count

Counting him out, as we lately discovered, is a provocative thing to do. In a piece published here last October, ''Keynes is dead, let's bury him'', we espoused views on the subject.

As we noted then Keynes had no theory of business cycles at all, except to say in a postscript to his "General Theory" that since he had explained everything, he must have explained cycles. This is paraphrasing his General Theory. Keynes's solution to the recession was simply "to avoid it in the first place," a policy which assumed away asset bubbles.

These claims drew a blusterous response from Keynes adherents around the world. Many seemed to take the Keynes observations as a personal insult. They love him almost as much as his biographer, whose own life reflects a form of hero worship, living vicariously through Keynes, in his old house no less. And since these claims inflamed such debate, their story is worth telling.

As far back as 1990, from the air space that was the 97th floor of the World Trade Centre's Tower One, co-author of this article, Andrew Boughton - then working with Deloitte & Touche in New York - sent Professor Peter Groenewegan at Sydney University a fax, seeking validation of a thesis called "Safe as Houses ... Safe as Banks'', along with a curious interpretation of Keynes.

Groenewegan was receptive and sent a copy to a Keynes expert and former Sydney University Political Economy student, Rod O'Donnell, now a professor at Macquarie. An ''inverted general theory'' gradually made the rounds of the Political Economy crowd.

A few years ago, University of Western Sydney's Professor Steve Keen took up the cudgels for real estate and finance, supported by the theories of Minsky and colleagues back at the Merewether Building at Sydney University, having long held an interest in the mathematics of political economy.

Keen, whose predictions of reckless leverage and speculation in recent years have been vindicated overall through the present credit crisis, declared this week that Australia was bound for a Japanese-style experience of drawn out recession. Stimulus measures were not resolving the problem, he said, simply adding to the Government debt.

The same theme was current in Boughton's earlier work, along with other correspondents in the United States such as Charles R Morris and Lowell Bryan, though he differs from Keen on the role of government.

While citing Marx on the proclivity of the ''parasites'', the banks, to ''periodically despoil industrial capitalists'' and ''interfere in actual production'', Keen noted that he did not expect capitalism to collapse.

Karl Marx, I presume

For many on the left, however, the current crisis is a first-rate opportunity to prove capitalism is a failure, from end to end.

The far left wants to change contemporary capitalism and all human relations. So to them. the core issue is not dysfunctional finance, but finance per se. Though the majority of workaday Keynesian economists would not agree, to the reformists who actually understood him, Keynes has always been an acceptable face for that agenda.''

Deep in Merewether, while Marx may be long gone the quest for the origins of the original demon, Capital, among the thickets of capitalism continues. A political economist ranges like an immortal Livingstone, forever seeking the source of the Nile in the African jungles. Or an undead Keynes, who, as part of the character of Dickon in HG Wells' "The World of William Clissold", is still ''thrusting in a sullen, persistent way through a dark jungle of finance ... in search of something vulnerable'.''

Criticising Keynes as a liberal fascist makes no friends in Political Economy. Even if crude Marxists see Keynes as the enemy for allegedly ''saving capitalism,'' deeper Marxist academics like Professor Frank Stilwell acknowledge a debt to Keynes and Mosley. Thus in a recent doom and gloom media interview (''It's a depression, I'm afraid''), University of Western Sydney's Steve Keen, sported a t-shirt with a quote from Keynes, though only Gerard Henderson seemed to have really noticed.

Devil's own bankers

The point about Keynes is that his personal beliefs had a profound effect on his economic theory. To imagine one at the centre of a milieu like Bloomsbury and The Apostles would allow their life's passion to sink into the desert of dry theory without an attempt to put across something more alive is certainly naive. His political essays and letters give it away, as does his biographer Roy Harrod when in the midst of an otherwise sanitised "Life of Keynes", a spectacularly candid passage on the heart of the General Theory fairly leaps from the pages.

"Money is the nigger in the woodpile ... if only the beautiful liquidity of money could somehow be destroyed ... Keynes accordingly had a good word for Gesell and his proposal for a stamped money which would depreciate.''

Money and finance is at the heart of fascism and communism, since it is the money nexus which degrades civilisation. Both systems seek to turn money into non-money, as Viktor Gerashchenko said of Soviet finance in 1990. Keynes attempted to pass a fascist currency system onto the West via the General Theory, which in a quirk of fate was used sixty years later to justify Shock Therapy in transitioning Russia away from just such a system.

This obsession with "the love of money-as-itself'' as the root of evil in Western civilisation also largely explains the persecution of the Jews under both systems.

In a soon to be released work on Keynes and fascist economics, co-author Boughton quotes the hitherto hidden appearance of JM Keynes in Wells' bible of the progressive left, at some length, and years ago even unearthed film footage of Keynes meeting with Henry Ford in Greenfield Village, Michigan, in 1925 in the visit referred to by Wells in the midst of the following passage:

''Dickon grapples now day and night with the mysteries of what he calls the Money Power. To release our dear Lady of Business from the paralysing grip of the Creditor is the final quest of his life. He is thrusting in a sullen, persistent way through a dark jungle of finance round about her in search of something vulnerable. He believes there is a concrete dragon somewhere in that darkness to be slain, and if so he will slay it. Wherever there is a promise of light upon these obscurities Dickon goes. Last November he was in Detroit in earnest conference with Henry Ford, who possessed, he thought, a peculiar point of view and special experiences about the evil thing. He crossed the Atlantic in winter for that. And he is developing an angry, industrious patience with currency and credit theorists. When he catches me in England he makes me talk about them. He wrangles with me and will not be denied. He talks now about money just as he used to talk once about advertisement - continually, with his heart as deeply in it ...'' As is evident in Keynes' own letters, Wells reports him as viewing bankers as the devil incarnate, with their mindless refusal to join the Wellsian ''Open Conspiracy'' for the greater pubic good.

''Apparently he cannot wring anything fundamental out of the bankers. I have heard him in his wrath denouncing them as 'beastly little Abacuses; rotten little roulette wheels, bagging the odd zero chance.' He clings to it that they are automata and have not the least idea of their role in the general economic life of the world. He compares them with the Freemasons, who 'had some sort of a secret once and have forgotten it.' He talks of 'going into banking' to find out.''

Better material for the Open Conspiracy were practical men of business and science like Henry Ford and Viktor Rothschild, the latter having befriended Keynes since Cambridge, as an Apostle, and having left the family's banking business for a life in industry and defence technology.

Anti-Semitic tilt

And as with Ford and Marx, Keynes' private world was filled to the brim with anti-Semitic banking rhetoric. Even his formal economics is replete with that catchcry of the Nazis, ''hoarding'', and his essays with 'making the Rentiers ''disgorge'' their ill-gotten gains.

When Keynes dined with Albert Einstein in Berlin he was sure that ''He is that kind of Jew - the kind which rarely has its head above water, the sweet, tender imps who have not sublimated immortality into compound interest.'' High praise indeed. ''Yet if I lived there'', he continued, ''I felt I might turn anti-Semite. For the poor Prussian is too slow and heavy on his legs for the other kind of Jews, the ones who are not imps but serving devils, with small horns, pitch forks, and oily tails. It is not agreeable to see a civilization so under the thumbs of its impure Jews who have all the money and the power and the brains ...''

This is probably not the Keynes our correspondents, indignantly defending Keynes' liberalism after our earlier piece, had in mind. Lest this be thought merely a sign of those times, bear in mind it led like-minded colleagues and friendly protagonists like Shaw and Wells to write this kind of thing, even in the late stages of World War II:

''The statesman ... must regulate the lives of the people on the assumption that ... up to a certain point for all purposes, women are all alike and men are all alike, though in fact none of them are quite alike. He must draw the lines between the classifications, and persecute or kill people on one side of the line and encourage and promote those on the other. And when he comes to the artist classification he, seeing the artists are the most effective propagandists, must make up his mind as to what doctrines to forbid and what to tolerate.'' (George Bernard Shaw, Everybody's Political What's What?, London, 1944. Quoted in 'GBS In Extremis', a review in The New Republic, September 20, 1944, p. 666-7.)

Or ''The Nazi movement is in many respects one which has my warm sympathy; in fact, I might fairly claim that Herr Hitler has repudiated Karl Marx to enlist under the banner of Bernard Shaw. You can therefore imagine my dismay when at the most critical moment Herr Hitler and the Nazis went mad on the Jewish question.'' (Gibbs, p. 355, quoting an interview with Haydon Church, Sunday Dispatch, June 4th, 1933). Not because this was unjustified, but politically unwise. A wiser way to contain the threat was to create a Jewish state. ''The Jews are worse than my own people. Those Jews who still want to be the chosen race (chosen by the late Lord Balfour) can go to Palestine and stew in their own juice. The rest had better stop being Jews and start being human beings. This is the real enemy, the invader from the East, the Druze, the ruffian, the oriental parasite; in a word: the Jew.'' (London Morning Post, December 3, 1925)

Aside from the distasteful nature of this sort of vast psychological projection - and the fact that the Nazis were fulfilling the harsh endgame of British liberal fascism - the real objection to Keynes, as with his opponents, is that they never focused on mundane real world events outside their own political dramas, on which their mathematical modelling should have been based. They were probably not that much interested. Keynes is often said to have been an excellent mathematician. To have added a couple of self evident ideas to flawed models, as economists do, is pointless. On a road trip you might as well say: ''Sure we're still lost, but we're in a faster car now and we're making great time.''

Real estate at the centre

At the Big Four audit firm KPMG in 1994, a senior audit partner in banking, John Buttle, sponsored and co-authored a paper with Boughton called ''Real Estate, Banking & Business Cycles'' in 1994, to see how general theory might look with real estate and finance at front and centre.

This was well received at the time by Westpac, which had neared collapse in the last property crisis of the early 1990s, and Macquarie Bank called in KPMG to help forecast short-term movements in their new property-based securities, which behaved ''differently'' to other securities, a near-impossible task at that stage. KPMG asked about their portfolio in Asia, which was growing, and gave the same advice as at the KPMG Industry Week Forum, which it was to exit within three years.

With the same paper, KPMG also approached the then head of the Reserve Bank of Australia, Ian Macfarlane, who lately joined the board of the ANZ, and Dr Claudio Borio, head of Research at the Bank for International Settlements in Basel, which establishes the Basel Risk framework used by bank regulators internationally, including APRA.

They also approached Wharton economists at the University of Pennsylvania like Susan Wachter, Dick Herring and Bobby Mariano, all Keynesians associated with the IMF and Housing & Urban Development in the US. All were receptive, bar the assault on Keynes. The BIS was already thinking along the same lines, and has since produced stellar work on the subject.

Yet this economic theory is far from accepted by the academic mainstream, and has yet to make a viable connection with the kind of near-term forecasts created from base data by teams of mathematicians and data vendors like Rismark and RP Data, or Australian Property Monitors and other consultants, or RBA forecasts.

So even now, a revised General Theory centred around metropolitan economics and finance has yet to emerge.

Fiddling at the edges

This means that the BIS and our local banking regulators face a long road ahead before truly drafting any regulations which can curb the deleterious consequences of real estate cycles. All they can to do is fiddle about the edges, and lament that cyclical stress testing is not taken seriously by banking executives.

This leaves risk managers in banks devoid of real decision-making authority around real estate portfolios and transactions. Indeed, so much so that in late 2005, experiencing trouble in parts of their portfolio and foreseeing more, the chief risk officers (CROs) at one Big Four Australian bank were reduced to asking a Big Four assurance firm to ''tell their general management'' that property cycles still existed.

''They believe property cycles have been banished forever'' said the head of property risk. ''We'd like someone to tell them it isn't true.'' In the event, the assurance firm demurred, preferring a soft landing.

To what theories and tools have governments resorted?

Now, in deference to the Big Four banks, with their huge commercial real estate exposures - and the spectre of offshore banks reticent to roll over Australian corporate loans as they head for home - the Government is proposing to prop up commercial property players with taxpayer money. And so it is that ''Rudd Bank'' has been borne, and ''social capitalism'' is its ideological licence.

Lessons from the Depression

But indeed, surely no responsibility sharpens the senses like that of heading a government in a Depression. It is instructive to revisit at least some political leaders from the 1930s, whose experience equally shows that in dealing with a crisis, pragmatism is everything, though of course some theory to manage its prevention would be infinitely better.

Jack Lang, the Premier of NSW in the early Depression years and more latterly Paul Keating's political mentor, had the greatest clarity of vision over the causes of the Depression, and this was the genesis of KPMG's work in the field. Lang wrote in his memoirs an account of the causal relationship between property lending in the 1920s and the Great Depression of the 1930s:

''During my lifetime, I have been through two great depressions. The first was the Big Bank Smash of 1893. The second was the Great Depression of 1929-32 ... after both there were pledges that they could never happen again. ... the events leading up to [both] were so similar ... First came the Great Boom ... The State debt appeared to have no limits ... But biggest of all was the Land Boom. It was a new kind of gold fever ... Everyone wanted to own land. There were fabulous stories of fortunes made buying and selling land.At the same time, builders were pushing up all kinds of structures ... Fancy prices were obtained for these dwellings from home-hungry families. So prices went up and up.To finance these land sales and building projects, a large number of building societies were established ... The societies worried little about costs or valuations. They had the money to lend, and out it went. The private banks found themselves in competition with these societies, so joined in the mad scramble to provide accommodation.Borrowers didn't worry much about their prospects of paying back the loans. They believed that the Boom was bound to last. Boom, Borrow and Bust ... First a number of the Land and Finance companies failed. Depositors lost their money, and those building homes were unable to complete them. Of course there were the usual promises that the banking system would be reformed.''

Lang was regarded as a radical firebrand in his day, and was accused by his opponents, particularly at the conservative Bulletin, of being a communist.

Yet he was a solid Labor conservative by today's standards, and had an eminently practical grasp not only of the causes of the Depression, but of the political possibilities of his situation. He had been a lawyer and a real estate auctioneer, and understood the business well.

While his scope to act was not as broad as today, it also became clear to him that a confluence of forces made the situation almost intractable, no matter what governments might attempt in practice or in theory. Deflation, the death spiral of our system, was almost inevitable.

Lang's memoirs were released in the later stages of the 1958-62 recession. A decade after came the crash of the early 1970s, a relatively minor recession in the early 1980s, the property crash and recession of the 1990s, and now the GFC. To paraphrase Lang, the events of each were strikingly similar.

Depression responses

The approach of the US Government was similar to Lang's, and found support from Keynes. While Roosevelt is usually seen as the Great Big Spender with his New Deal, it was his predecessor, the Republican president Herbert Hoover, who spent bigger before Roosevelt came on the scene, for which the conservative political historian, Paul Johnson, took him to task.

''From the very start ... Hoover agreed to take on the business cycle and stamp on it with all the resources of government. ''No president before has ever believed there was a government responsibility in such cases,'' Hoover wrote ''.... there we had to pioneer a new field''.''He resumed credit inflation, the Federal Reserve adding almost $30 million to credit in the last week of October 1929 alone. In November, he held a number of conferences with industrial leaders in which he extracted from them solemn promises not to cut wages; even increase them if possible - promises kept until 1932. Keynes, in a memo to Britain's Labour Prime Minister, Ramsay MacDonald, praised Hoover's record in maintaining high wage-levels and thought the Federal credit-expansion move had been 'thoroughly satisfactory.'''Indeed in all essentials, Hoover's actions embodied what would later be called a 'Keynesian' policy.''

Commenting as an historian, Johnson would have favoured Andrew Mellon's strategy of deflation to propping up bad businesses, perhaps similar to Malcolm Turnbull's approach today.

Yet the fact that banks were not guaranteed during the Depression was unquestionably a factor making it more severe and prolonged, and moreover, if by and large the rest of the business community was on the receiving end of a credit and asset shock, its failure as the Depression took hold was not so much bad business as bad luck.

Brilliant as his work may be in many respects, Johnson may also have erred in suggesting, in contrast to Keynes as well as recent history, that high interest rates rather than artificially low rates would have killed off the stock market boom of the 1920s.

Land speculation

Other historical evidence vividly corroborates Jack Lang's observations. Each major recession and banking crisis in Australia, from the establishment of commercial banks in the 1840s to the present, has been either directly precipitated or profoundly deepened by speculation in land and housing, often associated with railway construction.

"The first stage of the Depression,'' according to the noted historian of Australian banking Harry Nunn, "was the collapse of the land boom, the second the tightening of credit.'' Most historians view the 1890s depression in the same way, deepened by speculative investment in railways and wool.

Theories about finance, property investment and recessions began to emerge throughout the 1870-1940 period but never achieved a viable nexus with industrial theory. Astute observations were made by economists during the Great Depression on these relationships.

Mr. George H. Hull ... was so impressed by his observations of the relationship between fluctuations of construction work and periods of general business activity and depression, that he wrote a book upon the subject. (G. H. Hull, Industrial Depressions, F.A. Stokes Co., NY, 1911) ... Mr. Hull reviews the conditions accompanying six depressions, those of 1837, 1847, 1857, 1867, 1873, and 1882. Three of these depressions were accompanied by [bank] panics but he finds that in all three of these cases, the volume of construction work began to decline a long time before panic conditions appeared. The shrinkage amounted to more than 50 percent in 1836, a year before the panic of 1837. (George E. Roberts, ed, Economics for Executives: Panics, Crises, and Depressions, American Chamber of Economics, NY, 1921, pp. 28-302)

Another American text, first published in 1937, gave a clear description of the association between the growth of real estate loans extended by commercial banks in the US in the 1920s on inflated property values, and the onset and duration of the Depression.

''... the causes of many [Federal Reserve System] member bank failures were to be found in changes which took place in the nature of the loans and investments handled by these banks between 1921 and 1929.''... one type of loan seems to have been slighted during this period of rapidly expanding loans and investments. "All other loans," which include all ordinary commercial loans to business ... remained virtually constant during the period ... Whatever the specific causes may have been, it is an undeniable fact that, despite a 48% increase in total loans and investments, the member banks were performing their principal function of providing short-term business credit no more briskly at the end of the period than at the beginning.But during this period ... bank reserves were plentiful, and the Federal Reserve System ... quite consistently followed an "easy money" policy. Since banking is not a profitable business unless bank funds are kept at work, the member banks, in the absence of appeals for ordinary commercial loans, decided to lend in other fields. The identity of these fields may be readily established by reference to Table 36. From 1921 to 1929, member banks increased their loans on real estate by 214%, and their direct securities purchases and other investments by 67%. As a result of these changes, many member banks found themselves by 1929 in a position which raised doubts of their soundness as commercial banks.'' (Paul Gemmill and Ralph Blodgett, Economics: Principles and Problems, Harper, NY, 1937 (revised edition 1942), Ch 34, p. 71)

The data used by these American economists showed that the average rate of yearly increase in the volume of real estate lending between 1921 and 1929 was 17%, or nearly 20% if we exclude the sharp downturn during 1929. The average increase for commercial and industrial loans was zero, and the average for all business loans was 6%.

Other data from the 1920s as well as business cycles before and afterwards reflects the same phenomenon. The 1960s and 1980s exhibit a similar pattern, once we exclude external funding for takeovers, as do most business cycles in the nineteenth century, particularly when we take account of railway construction.

Henry George, the radical political economist who sold more economic texts than anyone before or since, first elaborated at real length the effect of rapidly appreciating real estate values on the incomes of business and consumers. He explained that speculation in railways was coincidental rather than causal.

The present commercial and industrial depression, which first clearly manifested itself in the United States in 1872, and has spread with greater or less intensity over the civilized world, is largely attributed to the undue extension of the railroad system, with which there are many things that seem to show its relation. I am fully conscious that the construction of railroads before they are actually needed may divert capital and labor from more to less productive employments, and make a community poorer instead of richer ... but to assign to this wasting of capital such a widespread industrial deadlock seems to me like attributing an unusually low tide to the drawing of a few extra buckets of water ...

Yet, that there is a connection between the rapid construction of railroads and industrial depression, any one who understands what increased land values mean ... can easily see. Wherever a railroad was built or projected, lands sprang up in value under the influence of speculation, and thousands of millions of dollars were added to the nominal values which capital and labor were asked to pay outright, or to pay in installments, as the price of being allowed to go to work and produce wealth.(Henry George, op cit, Bk. V, Ch. 1, Centenary edition, Robert Schalkenbach Foundation, 1979, pp. 274-275)

Psychology takes over

Economists have searched in vain for some aspect of Keynesian general theory to explain broad cycles, and have drawn a blank.

The best they can do is cobble together some abstract psychology - the idea that general gloom overtakes us in a boom period - with the self-evident notion that falling consumer spending compounds a general economic slowdown.

Meanwhile government counter-cyclical interest rate policy remains the pre-Keynesian one of raising interest rates to head off a boom, while using Keynes to justify high levels of government expenditure and garnishing their case with the virtues of fiscal policy.

The only other change has been in monetary policy. Realising that raising interest rates creates an international bidding war, the G-7 central bankers created an agreement in the 1990s to avoid such escalation, and have more recently acknowledged deflation as a greater risk than inflation in a falling property market.

While Keynes was undoubtedly right that raising interest rates would not head off a boom but surely induce and prolong recession, he failed to acknowledge - for reasons of a long term social agenda - that the investment resulting from abundant credit leads to chronic asset price inflation rather than industrial production.

Fatal flaws

This is the fatal flaw in his ''system''. And his view of causation, that a fall in consumption is due to a fall in consumer and investment confidence, is none the better for then describing the ensuing contractionary spiral. We all know that expansion and contraction are opposites, and that one is good and the other bad. But both parts of this Keynesian explanation are merely part of the same description.

We should be looking ahead of time for what causes the leading indicator to fall, instead of turning the description of a recession into its explanation.

If we accept that real estate cycles play a significant role in causing recessions and prolonging their duration, rather than following industry into and thence out of recessions, we would expect to see what historic observers have always seen, that a downturn in real estate and construction precedes other sectoral downturns, and vice-versa.

Our definition of "leading indicators" may be flawed. We inadequately separate causative indicators with longer lead-times and symptomatic indicators which appear on the eve of consequent events. The onset of a prolonged economic recession may be heralded by a downturn in construction and retail sales, but neither of these are the "cause" of the recession.

The concept of rolling recession emerged in the 1980s, with the idea that different industries experience their own cycles. Being devoid of any explanation for general cycles, however, it was insufficient to demolish the idea that general recessions are somehow caused by the onset of mass psychosis.

The only real change in macroeconomic management to take place during the twentieth century, as Friedman once observed, has been to insure banks against failure during recession. While governments have professed to be Keynesian but still use the classical theory in practice, which would come as a surprise to most of us, Keynes had the effect of removing our focus from what really causes cycles.

Not all farmland

Traditionally regarded as the problem child of the modern economy, with a manic temperament which renders it unstable, the property and construction sector has been left out of mainstream theory. Quite a feat, as this sector is the largest in the global economy.

Land, labour and capital prevail with capital being industrially-focused and land considered only as farmland. No urban, consumer and asset-oriented economic theory has emerged either independently of, or in concert with, industry economics.

Even a cursory structural review of the economy reflects a gross imbalance in the industry-centred model. Real estate and construction activity generally amounts to between 17% and 23% of GDP directly, and in most "industrial" economies exceeds the size of the manufacturing sector.

Recent data in Australia shows that even by 1993/94, housing credit relative to Australian GDP was some five times that of thirty years earlier. Dwellings and other buildings account for 55% to 60% of gross domestic capital formation in most countries, whilst plant and machinery typically constitute between 25% to 30%.

Banks exposed

The activity of the banking sector mirrors this structure in the economy, with real property accounting for a huge percentage of total bank lending. Not including government securities, a quick review of the accumulated and income producing wealth in an industrial economy reveals upwards of 45% of all wealth is to be found in property ownership and trading.

When we view the input-output models of any industrial economy, it is apparent that property and construction accounts for 25-30% of all economic activity on the basis of the value of direct activity, plus those components of manufacturing, services, utilities and government activity attributable to property and construction.

As a cost, rents and mortgages have progressively increased in real terms over the past three decades, while wages have slightly fallen. Industry has become more efficient, and the cost of consumer goods has progressively decreased.

Household expenditure on shelter is now higher overall in most economies than expenditure on food, and in some businesses, it is on a par with the cost of wages.

When we consider that buildings are used in all private and public activity, the inflationary implications of property price increases becomes still more apparent. Since real estate, like labour, is part of everything we do, it adds to costs at each stage of production, distribution and consumption, as well as feeding directly into wage claims.

In terms of costs, wealth, finance and employment, real property is as important to the economy as the entire manufacturing sector, particularly when we factor in its intimate association with banking and finance.

Given the structure of the economy and the financial system, and the fact that property cycles are far more pronounced and monolithic in nature than industrial cycles, the interaction of property and finance represents the only "event" which in itself is capable of enmeshing the entire economy in a general business cycle. It also represents a completely different set of relationships to that found in mainstream theory, because in this alternate view, industry is on the receiving end, not the initiating end, of business cycles.

Back to basics

What is real estate? The real key to understanding why real estate is so influential is to better define it.

Real property is at once the major investment and consumption good in our economy. It is also a quasi-monolithic, worldwide market, and despite the huge quality and locality differentials which exist, from an investment point of view it is not dissimilar to the major commodity markets. Unlike other asset investments such as the art market, it is a necessity, and is therefore its price is driven as much by inelastic demand as by choice.

Property is the economic bedrock, providing vital infrastructural support for virtually all economic activity, whether household, government or business. This infrastructure role is intimate. We physically live and operate within real structures.

The function of real property extends beyond the economic and into the social, and indeed structures are defined by economists as one of the three basic economic needs, the others being food and clothing. All other economic entities are naturally subordinate to these three.

Yet historically in economics, property has been treated as a productive resource, that is, productive agricultural land. Urban property has never been truly defined in economics, except by default as capital investment.

Why? It is many things to many people. Property resembles infrastructure, involving large amounts of capital, large-scale construction techniques, with large structures left at the end of day. It is an asset which can be traded, and like machinery, the structures depreciated.

The land on which a structure sits, and to a lesser extent the structure itself, is a reusable commodity which is not traded for consumption like other goods, but is permanently re-tradable. It is also fixed in place and cannot be imported or exported. Like finance, real estate is a facilitator of other economic activities - commercial, industrial and household. It is instrumental to being a consumer, trader or producer, but in itself produces nothing.

Yet it is also a direct cost overhead to businesses and consumers, rivalling the cost of salaries in many businesses and the cost of food in many households. To the consumer it is a major consumption item for which, like food, the demand is totally inelastic. And it is also a fixed asset which effectively never depreciates, making it - unlike a car or fridge or stove - an investment.

Property is also a services and manufacturing industry, which like the motor vehicles industry is of great importance to a host of other basic and complex goods producing sectors which supply it: steel, glass, aluminium, plastics, chemicals, bricks, cement, lumber and so on.

A huge number of professionals derive their living from the property sector, from architects and builders to interior designers and environmental planners.

Hybrid effect

So property is not exactly a consumption good, nor a capital investment, nor a producer good, or simply an asset.

It is a hybrid of all four, and not surprisingly, its market functions differently to any of them individually. Its supply and demand works more like that for asset markets than for consumer, producer or capital goods markets. In these latter markets, as prices rise, an increase in supply brings about price normalisation and thereafter a real long-term price reduction.

In property markets, when prices rise, so does supply. Prices do not fall to some equilibrium point where demand meets supply because the market has nothing to with supply and demand. On even a moderately rising market, the whole concept of equilibrium is not only irrelevant, but counter to what is going on. People are profiting from a perceptual shortage induced by an extraordinarily high degree of trading, as in a bull market in stocks.

Once the bull market is set in reverse, it takes a creative mind to see how it can be stalled. Everything collapses, including the huge trade credit regime threading through the construction supply chain.

Perhaps Professor Stilwell was right in one sense, when he remarked that if we had listened to Keynes and Mosley in the 1930s - though he meant the more radical rather than sanitised ideas, so we might as well add Hitler and Mussolini - the Depression may not have lasted so long and ended in WW II. On the other hand, perhaps Keynes himself is also right, at least in one respect, that the way to cure recessions is to avoid them in the first place.

Ah, if only he had the key. But then, he never went into banking to ''find out''.

Are we really going to once more make ''parasitic'' bankers once more the villains of the present drama, with Keynes reappearing as the Saviour, laissez faire relics and angry neo-cons as his foes, and let ourselves off completely? ''We have met the enemy, and he is us'' said Walt Kelly's Pogo.

Where are all those of all political persuasions who were about to make a fortune in real estate a couple of years ago? Or those with poor credit, at least before low-doc loans, angry that skinflint bankers were locking them out of the property escalator? All calling to lynch those who gave us the wherewithal to extract abundant wealth in real estate transactions from our neighbours.

The fact remains that until radical economists learn to focus on practical outcomes instead of trying to change human nature, and traditional economists fully accept and develop theories around the work of regulatory economists, and we learn that we can't all quit our day jobs to become property developers, it will all be forgotten as before, until next time.

*Andrew Boughton was formerly Director of Strategic Research & Analysis for KPMG US. He was also a consultant to Deloitte & Touche working on projects such as the reform of the Russian State Banking system for clients like AT&T and NCR. He is now a principal at Capital C Consulting in Sydney.